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Macroeconomic Conditions

US economic growth is expected to decelerate, with the risk of a mild recession in H2 2023 or early 2024. A severe credit crunch could occur if lending is significantly constrained at regional and community banks, especially if deposit outflows or loan losses continue to rise.

US economic growth is decelerating and may contract faster if regional bank lending slows significantly.

The ISM Manufacturing and Services Index surveys came in well lower than expected for March.  Manufacturing has already been weak for several months (below 50 for the last four months), but the services growth slowdown was more unexpected (index reading of 51.2 vs. 55+ over the prior two months).  Both manufacturing and services surveys showed developing weakness in new orders.  

Most economists are presently forecasting a mild recession to begin in H2 2023 or early 2024 (although this prediction has consistently been pushed back over the past six months).

Economists are concerned about rising risks for a severe credit crunch if lending is sharply constrained at regional and community banks, driven by higher deposit outflows or increasing loan losses (especially commercial real estate loans).

Encouragingly, confidence in the US regional banking system is stabilizing as borrowings from Fed facilities have steadily declined over the past couple of weeks (vs. the initial flurry post the SVB collapse) and deposit outflows have abated.

Commercial bank lending dropped by $105 billion in the last two weeks of March, the largest drop since 1973.   The pullback in lending was relatively broad across both real estate and commercial and industrial lending.  However, loan issuance stabilized in early April.

Thus far, banks have reported strong Q1 earnings.  Large banks have increased their outlook for net interest income while regional banks are expecting modest net interest income contraction.  Credit quality remains very strong although banks are increasing loan loss provisions to account for potential increases in defaults should economic conditions worsen.   

Large banks have gained deposits since Q4 2022 – while the smaller banks have experienced deposit reductions (both in terms of customers switching deposits to larger banks or seeking out higher-yielding investment options).   Fortunately, deposit outflows for regional banks have stabilized in April and have been generally in line with analyst expectations.  

Several questions arise regarding the true level of regional and small community banks’ exposure to commercial real estate, especially the office sector (covered in more detail in our special topic.) 

Per Moody’s, US banks are estimated to hold roughly 30% of the $4.5 trillion of US CRE debt outstanding.

Presently real estate defaults are very low. However, with a large wall of real estate debt maturing in 2023 and 2024, investors expect CRE defaults to increase and are concerned that could cause to banks to become more cautious, reducing new lending (both to CRE and more broadly across the economy).

Over $1.3 trillion of the $4.5 trillion of outstanding CRE Debt is maturing through 2024 ($700bln of this maturing debt is held at banks).  While defaults are expected to increase and many properties will be unable to refinance and secure new loans, actual losses for banks are forecast to be quite low.   Lending standards were much more conservative after the GFC, with lower loan-to-value limits and substantial equity cushion behind the loans.   With most properties having experienced strong NOI growth over the last 5-7 years, property values are likely to have appreciated for most property types (except for challenged office buildings and certain retail properties).   As such, with realized losses expected to be quite low from commercial real estate, banks are unlikely to experience material balance sheet stress and thus are less likely to severely curtail lending activities.  

Consumer spending sill remains strong with consumer balance sheets were still estimated to hold over $1 trillion of excess pandemic-driven savings (relative to $2.5 trillion at the peak).  

However, most economists forecast this savings buffer to be depleted by H2 2023, or early 2024, and savings rates are at all time lows while credit card balances are at all time highs.    

While consumer credit quality remains very strong, delinquencies are increasing steadily and defaults could quickly pick up if layoffs intensify.

Canada is expected to deliver very modest growth in 2023.

Economists are expecting a more pronounced slowdown in residential investment and goods consumption, with demand for services dropping as the year goes on.  

A potential downturn will impact different regions unevenly.   Economies more dependent on residential real estate, construction, and the sale of durable goods (Ontario and British Columbia) could see harsher impacts whereas provinces producing commodities should fare better (Saskatchewan, Alberta, and Newfoundland).

The labor market remains very tight with record-low unemployment and over 1 million unfilled vacancies.  Given the current labor shortages, an economic downturn may result in slower hiring and fewer hours worked rather than wholesale layoffs.

Europe has thus far avoided a recession with growth much better than feared.  However, headwinds and a mild recession (base case) loom ahead.

The combination of mild winter weather (energy crisis averted), household and business support by governments, and tailwinds from China’s reopening have all contributed to better-than expected-performance in 2022 and thus far in 2023.  

Furthermore, Europe benefitted from a catch-up in Industrial production during 2022 as pandemic restrictions were lifted and firms were able to fill backlogged orders.  

However, new orders have declined significantly thus far in 2023.

Increasing core inflation is likely to result in continued interest rate increases (deposit facility rate expected to peak at 3.5% or higher in summer 2023) which will manifest themselves through curtailed economic activity with a lag as we progress through 2023 and into 2024.  

China is well positioned for above-trend growth in 2023

China GDP growth for Q1 at 4.6% comfortably eclipsed analyst forecasts of 3.5%.

Demand for services has increased rapidly with the Caixin Service PMI registering 57.8 in March (up from 55.0 the prior month and the highest reading in over two years).

This rapid services growth and uptick in domestic demand will be partially offset by slowing export growth driven by lower external demand. 

Government stimulus is expected to increase post Q1 2023 which should help support the critically important property development sector.  

Finally, government regulatory posture towards the internet, technology, and ecommerce sectors is becoming more friendly.  This should benefit major large-cap companies such as Alibaba and Tencent. 

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